Support for agricultural credit and rural finance, a large part of the Bank's agricultural program for the past 45 years, has recently come under criticism and been substantially cut back. Agricultural credit projects have sought to increase agricultural investment, improve farmers' access to credit, and strengthen institutions. Increasingly in the last decade, credit projects have also sought to improve the rural financial system as a whole. The different emphases given to these multiple goals have been a focal point of policy debate. A recent OED study examines the criticism of traditional agricultural credit operations against the experience of several decades. It suggests that the Bank's judgment of its agricultural credit portfolio has been too dismissive and that a more balanced approach combining production, equity, and institutional reform objectives ought to be used in future credit operations.
Evolution of Bank policy
The traditional model for agricultural credit began to be criticized in the 1970s for providing credit largely to increase production, rather than encouraging intermediation between savers and investors as a goal in its own right. Other objections followed...to its alleged indifference to mobilization of savings, inadequate targeting, reliance on overprotected agencies, and, especially, the use of below market interest rates, which was seen as ineffective in reaching production and equity objectives, and destructive in its impact on financial systems. These objections gave impetus to a new policy, gearing credit operations to reform of rural financial markets (see Box 1).
Many of the objections are reflected in the Bank's Operational Directive 8.30 (February 1992). The policy sets stringent conditions on subsidy levels, preferential targeting, collection performance, portfolio profitability, and other institutional tests that staff have seen as prohibitive. It acknowledges targeted subsidies to be helpful to "infant industries", for meeting other credit demands blocked by market failure, and for offsetting disincentives created elsewhere in the policy, pricing, and regulatory regimes, but it calls for the adjustment period to be kept brief.
As soon as the directive was issued, agricultural credit operations in the pipeline were reformulated, suspended, or dropped. The Task Force whose work underlay the directive had intended a gradual redirection of the portfolio, but its argument was overstated and its message misinterpreted.
Agricultural credit operations financed by the Bank fall into three categories: self standing projects featuring targeted or untargeted credit to voluntary beneficiaries (individuals, cooperatives, firms); comparable projects, but without voluntary beneficiaries, in five "socialist" countries; and credit components of multipurpose agricultural projects.
Among the 94 countries that have borrowed for agricultural credit, 30 account for 91 percent of the $16.5 billion approved to date. Brazil, India, and Mexico are the largest borrowers, each with over $2 billion approved.
The bulk of lending for credit was approved from 1975 to 1983, when commitments peaked. A sharper, further drop in lending in 1989 is attributed to circulation of the Task Force Report and draft OD.
Among completed agricultural credit projects, the proportion rated unsatisfactory has remained around 28 percent over the last 20 years. Among credit components, by contrast, unsatisfactory ratings have risen from about 30 percent to 55 percent.
Hard evidence about the impact of credit on production and equity is notoriously difficult to secure. Nonetheless, the evaluation evidence used for the study provided ample basis for commenting on the progress and quality of the Bank's portfolio during its years of major growth. The study focused mostly on credit projects, rather than on credit components, since the projects made up more than 80 percent of Bank agricultural credit lending and were also the focal point of criticism. All these projects provided medium and long term credit associated with investment programs on farms or in agroindustrial and marketing firms. Some also offered seasonal or other short term finance. Most of the projects were approved in the early 1980s and completed before 1990.
The findings, based on completion reports by Bank operational staff, and performance audits by evaluation staff, suggest that the positive contributions and impact of credit projects have been underestimated. The projects:
- made important contributions to increases in crop, livestock, and industrial production;
- fostered substantial improvements in assets (irrigation equipment, terracing, herds, and buildings);
- were an effective vehicle for transferring unrestricted foreign exchange and balance of payments support;
- positively affected the capability and image of the implementing agencies.
Few of the projects addressed the problems associated with subsistence farming, yet they succeeded in reaching small commercial farmers.
Borrowers in the projects studied rarely diverted subsidized credit to investments other than those intended. Other negative effects...such as substitution for funds from other sources, crowding out of other lenders...often associated with targeted credit subsidies were uncommon. The review found no evidence that cheap money strategies were deliberately associated with the Bank's assistance for credit.
However, project design typically paid little attention to the mobilization of rural savings. For most of the credit institutions, financial viability is still a distant goal; reasons include high delinquency rates in some countries, and rapid decapitalization due to accelerated inflation and negative interest rates in others. The Bank made little intellectual contribution to methods for managing delinquency, to the development of appropriate criteria for assessing eligibility for loans or for debt rescheduling. Limited institutional development support was provided to help restore the financial health of ailing intermediaries.
Traditional credit projects sought to provide credit to groups in need of support. Criticisms that these projects failed to address systemic problems are substantiated, as are assertions about the poor performance and lack of financial viability of credit institutions represented in the portfolio. Failure to raise collection rates was nearly universal. Some institutions, dependent on portfolio and government transfers that are no longer reliable, are at risk. Thus, criticism of the banking side of agricultural credit is mostly valid.
Yet agricultural credit programs supported by the Bank have had a useful development role, especially when measured against their original goals, and when assigning adequate weight to increases in agricultural production and access by farmers to this vital input of rural capital formation. Farm level investments have matched expectations. Moreover, the Bank's role in motivating reform in many country programs throughout the 1980s, though difficult to gauge, cannot be ignored (see Box 2).
It would be wrong to conclude that the agricultural credit portfolio has been a failure, or that a sharp decline in Bank lending was warranted for that reason. Lending to private investors who largely appear to have used credit well, and advancing toward the goal of getting the bulk of the funds back in real value to lend again, while creating an institutional setting to safeguard that rotation, are achievements that rank credit operations highly in the Bank's agricultural program as a whole. In short, the harsh judgment of the agricultural credit portfolio was too sweeping and a large part of the criticism is not supported by the documented record.
Gradual, rather than sudden, transitions toward market based credit policies make sense in many countries. Experience suggests that the Bank can afford to compromise on issues such as managed targeting and interest rate subsidies without risking the loss of production objectives or compromising the viability of credit agencies. Patient dialogue over a series of projects more often than not is rewarded by substantial, cumulative movement toward rural financial market reforms. What appears to some critics as yielding, under pressure, to noncompliance on critical policy issues may often be viewed as sensible sidesteps to keep reasonable programs moving. Graduated responses to the evolving performance of intermediaries rather than abrupt interruptions in the relationships are more likely to produce sustainable institutional development.
Review Bank policy toward agricultural credit and rural finance. The logic underlying such credit programs remains sound, though recent experience suggests some modifications are desirable.
- Revise OD 8.30.
- Prepare a new policy paper for rural finance.
Reconsider the role of rural finance in agriculture sector strategy. Agricultural credit programs are most valuable when they service agricultural policy reform and form an integral part of the deliberate development of rural institutions. The sector context should be brought up at project appraisal and an appropriate strategy agreed. Emphasis should remain on longer term credit lines, complemented as necessary with working capital and other short term finance associated with the investments. Other aspects that deserve attention:
- Recycling Bank funds at longer terms.
- Establishing the appropriate role for targeting and subsidies, in the context of overall sector strategy.
- Improving instruments to finance small farmers and disadvantaged groups.
- Building up the Bank's capacity to provide institutional development assistance to agricultural credit agencies.
Strengthen the financial dimensions of the agricultural credit portfolio. In reconstructing the agricultural credit portfolio, the main concerns of RFM reform should receive at least as much attention as production objectives. The portfolio should be upgraded over time, to support the development of full scale financial intermediation.
Bank Management has stated that most of the recommendations of the OED study are in fact part of the Bank's existing policy thrust. There is no need to produce a new rural credit policy paper at this time, though we agree that on some issues the policy needs clarification. The present policy seeks to promote better rural credit projects by requiring explicit discussion of the justification for subsidies and targeting, and a detailed evaluation of the adequacy of the institutional capacity and policies within the specific country context. Though some people interpret the policy narrowly, it is not unduly restrictive nor does it disallow well designed rural credit operations.
An important ingredient in designing better rural credit projects is a focus on the institutions and the policy framework. Neglect of the institutional aspect increases the risk of unsustainability; this has indeed been an alarmingly deficient aspect of many past rural credit operations. Financial discipline is a proper reflection of lessons learnt.
It is important to reaffirm that Operational Directive 8.30 does not preclude the use of targeted credit or of justified subsidies. But it does insist that these interventions be made within a sound sectoral and operational context. Resource misallocations due to financial policy deficiencies, institutional weaknesses, and unstable macroeconomic conditions need to be addressed before Bank funds are channeled on a major scale.
Operational Directive 8.30 will be reformatted by June 1995, to provide ample guidance on issues such as justification for subsidies and targeting, analysis of arrears and defaults, and prevention of decapitalization.
Following its normal practice, the Joint Audit Committee of the Bank's Board of Executive Directors considered the OED study and the Management's response. Issues discussed by the Committee included the importance of monitoring and evaluation and of institutional development in credit projects assisted by the Bank, the case for subsidies and targeted credit, and the case for a new policy paper on rural credit. Members emphasized the need for realistic approaches to deal with the very specific problem of making credit available to remote rural areas. They welcomed the proposed recasting of OD 8.30 and the narrowing gap between the views of OED and management on the issue of enhancing access to credit in the agricultural sector, a development imperative to many of the Bank's clients, particularly the lower income countries. There was a need to acknowledge the specific problems of making credit available to remote areas and the rural poor. Lack of data made it necessary for all relevant units of the Bank, including the Research Department, to engage in some in depth study in this area. Management would decide the most appropriate way for these efforts to mesh. The issue would be revisited in due course, probably in two to three years.
Box 1: Rural Financial Market Reform
Proponents of reforming rural financial markets object to traditional agricultural credit projects on the grounds that:
- Rather than encouraging intermediation between savers and investors, traditional credit projects only provide credit for production objectives. Instead, support for credit should be balanced by comparable efforts to mobilize rural savings.
- Subsidized lending may not be an effective way to encourage small farmers to adopt modern technology: evidence shows that the link between low interest rates and procurement of technology is tenuous and that banks in fact redirect funds to large rather than small farmers.
- Farmers may use directed, subsidized credit for purposes other than intended by the project. This is particularly true for credit designed to support seasonal inputs such as fertilizer; it may also be true for credit for major investments such as wells or tractors. Where this happens, it is argued, project funds replace other funds that farmers would have used for these purposes.
- Cheap money does not inspire farmers' commitment to the enterprise or technology financed, or to repay the loan. A demand driven credit system, responding to farmers' needs rather than to projects' priorities, enhances this commitment.
- Credit agencies themselves suffer from subsidized interest rates. The subsidies cause losses, on top of those caused by high arrears, and undermine the agencies' financial sustainability. Low interest rate ceilings discourage other banks from entering the market.
- The argument that subsidized interest rates offset excessive export taxes, low producer prices, and other disincentives to agriculture is flawed: all farmers are hurt by the disincentives, but only a few get loans.
The study found that most of these objections did not properly reflect the conditions of the Bank's credit portfolio.
Box 2: Policy Reform in Brazil, Colombia, and Mexico
In several countries in the 1980s, the Bank's analytical work and policy advice advocating interest rate reform found increasingly receptive audiences.
In Colombia, dialogue with the Bank at the project and country levels helped increase the government's awareness of the costs of subsidies and directed credit, and, eventually, to an important government policy reversal. Colombia, like many Latin American countries, had preferred to fix indexes at a rate beneficial to farmers (a preference that was subsequently intensified because of unanticipated high rates of inflation in the region). Colombia was outspoken in favor of negative real rates until the late 1980s, when it reversed its position completely, partly in response to Bank dialogue. This reversal opened the way to a $250 million RFM loan recently approved.
In Brazil, the Bank provided crucial support to the government on the reversal of rural credit subsidies. Mostly between 1978 and 1985, subsidized interest rates on official loans led to a widely recognized exodus of private funds out of agriculture, condoned by the commercial banks. Prompted by the gravity of the situation, and particularly the growing fiscal burden of the subsidies, the government raised the index applied to interest rates to match the level of inflation. The Bank supported this policy reversal by providing three large loans in this period and by helping to define new lending procedures.
Mexico's 1984 General Agreement on Interest Rates, resulting from policy dialogue between the Bank and the government, was intended to ensure positive interest rates on most loans in all Bank assisted credit projects. When the agreement was signed, inflation was expected to fall. Instead, inflation accelerated, and the government resisted raising interest rates in tandem. Though the Bank imposed a series of informal suspensions of disbursements on its loans, compromises were reached and funds disbursed. Rather than diminishing authority or damaging the operating systems, the compromises helped to strengthen the implementing agencies. Today, the Mexican government maintains a firm position on positive interest rates, even in the small farmer portfolio, a position unthinkable ten years ago.